I received a good suggestion from @rocketbeee in a recent post (@bitgeek/complete-correlation-matrix-for-poloniex) to investigate the correlation between cryptocurrencies and something like the S&P 500 so… I have done just that and a little bit more.
This analysis demonstrates one of the biggest benefits of Bitcoin and cryptocurrencies to the investment world in my opinion. I am by no means an investment expert but I do understand the benefits of having a diversified portfolio. It is often said “you should never put all your eggs in one basket” and this is particularly true in the case of investments. For those who are unfamiliar with diversification benefits I will give a quick explanations. Suppose there are two shares I can invest in and both provide an expected return of 5% per year. However, I also know that the shares are negatively correlated (meaning the prices generally move in opposite directions). By investing in both shares (instead of putting everything on one) the negative correlation will cause the volatility of the portfolio to be lower than if I put all my money in either of the shares on their own. Volatility is a fancy word for risk and investors dislike risk (unless they are rewarded to reflect it). However, in this example, the expected returns are the same regardless so a rational investor will chose to spread (or diversity) their investments across both shares. This is diversification benefit.
And now to the purpose of this article and the point of my introduction above! As we live in an increasingly globalised world where markets are becoming more connected and influenced by one another, it is getting more difficult to find investments with low correlation. This is where Bitcoin comes in!
This analysis looks at how Bitcoin (which in this article is meant to reflect the whole digital currency world for simplicity) is correlated with the other investment markets around the world. For the latter, I have chosen the S&P 500 as this a good indicator of the performance of equities in some of the largest exchanges. So we are basically looking at Cryptoworld Investments VS Traditional Investments.
I would like to bring you through the graphs below. The first is just a nice one showing the incredible performance of Bitcoin versus the S&P 500 since 2013. It just shows how Bitcoin’s performance has completely dwarfed the (quite good) returns seen by the S&P 500 over the same period. It should be said that Bitcoin is much more volatile than the S&P (see bottom two graphs below).
The next illustration (while graphically not very interesting) really demonstrates the point I’m trying to get across here. You will see the correlation between Bitcoin and the S&P 500 over the period since 2013 is 3%. The correlation scale ranges from -100% to +100% and 0% implies completely uncorrelated so a 3% correlation is near-uncorrelated. So, what does this mean for Bitcoin and other cyrptocurrencies? It means that Bitcoin offers investors around the world a way of reducing their portfolio risk. This is why I think the sub-$100bn market cap is just the beginning. The more accessible Bitcoin becomes, the more money I see flooding into this space.
Thank you for reading.
